When applying for a loan, most people focus on the amount they need to borrow and the monthly repayment they can afford. However, there is another important factor that can have a significant impact on how much you will actually pay over the life of the loan. That factor is your credit score. Understanding the link between your credit score and loan interest rates could save you hundreds or even thousands of pounds.
In the UK, lenders use your credit score to measure how risky it might be to lend money to you. The higher your score, the more likely you are to be offered lower interest rates. If your score is lower, you may still be approved for a loan, but the interest rate is likely to be higher. Let’s explore why this happens, how it works, and what you can do to put yourself in a better position before you apply.
How Credit Scores Work
Your credit score is a number that represents your creditworthiness. It is calculated based on the information in your credit report, which includes your payment history, the total amount of debt you owe, the types of credit you have used, the length of your credit history, and recent applications for credit.
Different credit reference agencies use slightly different scoring systems, but the principle is the same. The higher your score, the less risky you appear to lenders. This is why it is important to check your credit score regularly so you know where you stand before making a loan application.
Why Interest Rates Change Based on Credit Scores
When lenders decide what interest rate to offer you, they are effectively deciding how much risk they are willing to take. A borrower with a strong track record of making payments on time and managing credit responsibly is considered low risk. As a result, they are offered lower interest rates because the lender expects they will repay the loan without issues.
On the other hand, if your credit score is lower, lenders see you as a higher risk. They will often offer a higher interest rate to offset that risk. In some cases, the difference can be significant. Over the life of a loan, even a small increase in the interest rate can cost you a lot more.
The Link Between Your Credit Score and Loan Interest Rates in Practice
To see the link between your credit score and loan interest rates in action, consider two people applying for a personal loan of £10,000 over five years.
- Person A has an excellent credit score. The lender offers them an interest rate of 3 percent. Their monthly repayments might be around £180, and they will pay just over £800 in interest over the five years.
- Person B has a poor credit score. They are still approved for the loan, but the interest rate offered is 12 percent. Their monthly repayments rise to about £220, and they will pay over £3,000 in interest by the end of the loan term.
This example shows why understanding the relationship between credit scores and interest rates is so important. The same loan amount can cost dramatically different amounts depending on your credit profile.
Factors That Affect Both Your Credit Score and Interest Rate
Several elements influence your credit score, and these same elements can indirectly affect the interest rate you are offered. These include:
- Payment History
Consistently paying bills, loans, and credit cards on time is one of the most important factors. Missed payments can have a negative impact that lasts for years. - Credit Utilisation
This is the percentage of your available credit that you are using. Keeping it low shows lenders that you are not overly reliant on credit. - Length of Credit History
A longer history of well-managed credit accounts can improve your score. - Types of Credit
Having a mix of credit types, such as credit cards, loans, and store accounts, can be beneficial if they are all well managed. - Recent Applications
Multiple applications for credit in a short space of time can lower your score temporarily.
Why You Should Check Your Credit Before Applying
Before applying for any loan, it is sensible to check credit online to make sure your report is accurate and up to date. Errors in your report could lead to you being offered a higher interest rate than you deserve. If you spot any mistakes, you can raise them with the credit reference agency to have them corrected.
Using a free credit score checker can also help you monitor changes in your score over time. This allows you to work on improving it before you apply for a loan, which could lead to a lower interest rate and reduced repayments.
Improving Your Credit Score to Get Better Rates
If your score is lower than you would like, there are steps you can take to improve it before applying for a loan.
- Pay all bills on time – This is one of the quickest ways to show reliability.
- Reduce outstanding debt – Bringing down your balances can have a positive effect.
- Avoid unnecessary applications – Each new application leaves a footprint on your file.
- Register on the electoral roll – Being listed at your current address can help verify your identity and boost your score.
- Keep old accounts open – A longer credit history can work in your favour.
Even small improvements can make a difference to the rate you are offered.
Short-Term vs Long-Term Loans
The impact of interest rates is particularly noticeable on long-term loans. Over five or more years, the difference between a high and low rate can run into thousands of pounds. Short-term loans will also be affected, but the total extra cost is usually lower simply because the repayment period is shorter.
However, a lower interest rate is always better, and improving your score before applying is almost always worth the effort.
The Role of APR in Loan Comparisons
When comparing loans, look at the Annual Percentage Rate (APR). This figure includes both the interest rate and any fees, giving you a clearer picture of the total cost of borrowing. Lenders are required to display a representative APR, but remember that this may not be the exact rate you are offered. Your personal APR will depend on your credit score and other factors.
Understanding how APR works helps you see the real effect of the link between your credit score and loan interest rates. Two loans with similar advertised rates can have very different total costs once your personal rate is applied.
Final Thoughts
The link between your credit score and loan interest rates is one of the most important factors to understand before borrowing money. A higher score can mean access to the most competitive rates, while a lower score may result in significantly higher costs over the life of the loan.
By taking the time to review your credit report, using a free tool to track your score, and making improvements where possible, you can put yourself in the best position to secure a loan with a favourable rate. The effort you put in before applying could save you a substantial amount of money in the long run.
